My opinions on value investing. The idea is to create a value discussion on stocks and concepts. You might find this blog leaning a bit towards Dalal Street but the concepts should travel well across global markets.
Please note that I may or may not have a position in these stocks. Please use these opinions after through independent research and at your own risk.

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Monday, March 23, 2015

Leverage: The fastest & most likely way to go bankrupt

“If you're smart you don't need it, and if you're
dumb, you got no business using it."

-
Warren Buffet

Leverage is used by many funds (hedge fund more than mutual funds) as a
financial tool to improve returns. Now in the value investing world of equities
leverage can be a very dangerous thing. Leverage increases your chances of
going bankrupt rapidly. A portfolio management strategy with 1:1 leverage that moves down 50% will
be out of the money and the game will be over for the investor. Typically in
the value investing world a market move downwards of 50% is a wonderful thing
as it provides many opportunities to the intelligent investor. Value investing should
then require you to hold a minimum percentage of cash (arbitrarily let’s say 5%)
so that in the extreme “six sigma” event you can attend the buying party. For the uninitiated a six sigma event should mathematically
occur 0.00034% of the times but in the markets when the going is good the markets
find it very unlikely that a 30% fall will happen. And every time it does happen
some people start (wrongly) calling it a “six sigma” event. This so called six sigma even seems to happen once or sometimes even more times a decade.So in the value investing
communities a “six sigma” event is a buying party!

Implicit leverage via the use of insurance
contracts, options and other derivatives is also a dangerous thing unless you
really know what you are doing. Even Berkshire uses this mode of insurance
floats and short option positions. But getting to a stage where you can value
such instruments and can manage that kind of risk is way outside my circle of
competence and the scope of this book. Just to note a hedge fund that is short a long term insurance contract is a very dicey thing because a hedge fund does not have permanent capital. Thankfully mutual funds are not allowed do such exotic things and are better regulated on most jurisdictions.

This absolutely does not mean that the
businesses you invest in should not be using leverage. But they too need to be
using it within limits. Banks will of course use the most, but they should have
their capital adequacy ratio in check as per the latest Basel norms.
Manufacturing businesses often use leverage but I think anything that is
levered more than three times debt to profit after tax should be looked at with
a skeptical eye. The business itself could go bankrupt. Anecdotally very rarely
do I come across with business with more than one times debt to EBITDA of debt
that has good returns on capital. I have looked at over 140 companies in the Indian
markets and from the ones I have looked at the average ROCE goes down as the debt/PAT
goes up. Yes this is not a random sample but one which contains companies that showed
up on some screen or the other but still gives you a sense of why leverage is the
fastest way to go bankrupt. This data excludes banks.